A “legacy-equity” mechanism to recapitalise the banks

The Legacy Assets Program announced by Secretary Geithner earlier this week has the right elements to deal with a crisis where liquidity and uncertainty problems have greatly exacerbated the structural problems behind the crisis (see my blog reaction here). However, this program also has increased the urgency to activate the CAP (Capital Assistance Program), since otherwise many of the banks may be unable to cleanse their balance sheets for fear of (temporary) insolvency.

Complementarity of CAP and LAP

The Treasury has highlighted the complementary nature of these programs in countless occasions. Less clear is the final form the CAP may take. As of now, we know that after the stress tests are concluded, banks that have insufficient capital to overcome an extreme macroeconomic scenario will be given a window of time to raise private capital or to apply to a contingent convertible preferred shares program. This is a sensible approach, but I believe that a relatively small modification can significantly raise the participation of private capital in this program.

In previous writings on Vox, I have proposed that the government pledges a minimum future (for example, five years hence) price guarantee for new equity raised by banks during a narrow window of time. I have shown that in a highly uncertain environment like the current one, this guarantee could boost the price of equity by substantially more than the value of the guarantee itself. This increase in the value of equity would entice banks to raise guaranteed private equity because the dilution would be much smaller than if done at the current fire sale prices. Also, since the guaranteed price would be significantly lower than the new equilibrium price, this plan would expose the taxpayers to only a fraction of the risk that they are exposed to in a direct public-equity injection plan.

One problem with such proposal is that it is a bit “too different” from the way things are normally done, which raises not only suspicion but also implementation hurdles. However, here I argue that this is no longer the case since one can achieve very similar results by extending the mechanism used in the Legacy Securities Program to banks’ new equity.

Using LAP-like mechanism to new bank equity

“Mutual fund” managers can raise private capital to invest in distressed banks’ new equity, supported by a Treasury equity co-participation and a (non-recourse) loan from the Fed. These funds would be required to follow a predominantly buy-and-hold strategy. Since equity markets are more liquid and better able to manage volatility than other financial markets, I suspect that both the leverage ratio and the public-equity participation in this instance could be significantly smaller than the equivalent ratios in the Legacy Securities Program (for example, the leverage ratio could be capped at two and the public-capital participation at 30%).

The disadvantage of this “Legacy-Equity” approach relative to the pure equity-guarantee approach is that it requires more upfront public resources. The advantage is that there is already a clear template for how to do it, although it may require extending even further the type of collateral the Fed can accept (or it may need to bundle the equity with a put option written by the Treasury, in which case we are back to the equity-guarantee model but for a portfolio of banks’ shares rather than for the shares of each bank separately).

The funding part of this program is not too different from the model used by the Small Business Administration in its SBIC program to support private capital.

Originally published at Vox and reproduced here with the author’s permission.